Friday, October 30, 2015

Comments on the blockbuster Valeant conference call

Note:About ten minutes after I posted this blog Valeant terminated its relationship with Philidor. The liability questions at the end of this post now have greater importance. I have left the post unchanged for that announcement. Enjoy.------------Original post:

Forgive a long post. The Valeant/Philidor/US Attorney situation is complicated. The pattern of this post will be to state both what we know and how we know it - and to explore theories around the edge of that knowledge. Because the underlying situation is complicated the post will unfortunately be detailed and at some points non-committal.

Almost anyone who has been following Wall Street will know that Valeant Pharmaceuticals, a large-cap and previously acquisitive pharmaceutical company, has been under pressure. They held a special conference call to answer concerns raised by Citron Research (a prominent individual short-seller), The Southern Investigative Research Foundation [SIRF] (see here and here), the Wall Street Journal (notably this article) and this blog.These articles focuss on a specialty pharmacy (Philidor) which distribute almost entirely Valeant products, have close interchange with Valeant staff, and is quite large (targeting 1000 staff by the end of this year). This was never disclosed by Valeant prior to the SIRF article. The main sources for these articles were two court cases in California where a Philidor associate, another specialty company called Isolani was suing R&O - a small specialty pharmacy company in California.The complete prior lack of disclosure about Philidor (which is clearly important to Valeant) allowed several wild theories to develop. Some of these theories (including theories I had) were wrong. Others are almost certainly correct. Some of these theories allege criminal activity by Philidor. Valeant has disclosed criminal investigations by two US Attorneys. If any of the criminal theories are correct it will be very bad for Philidor. Whether it is similarly bad for Valeant was one of the topics of the conference call and hence of this blog post.The most prominent allegation in the various articles came from Citron Research. That allegation - that the tied specialty pharmaceutical companies are being used for channel stuffing is almost certainly false. Valeant spent a disproportionate amount of time on this allegation - perhaps at the expense of ignoring the problems identified by SIFR, the WSJ and me. Whatever: let's take the conference call seriously.The more pertinent allegation is that Philidor is an artifice for defrauding insurance companies. This was inadequately addressed in the conference call. However it is the elephant in the room.Valeant's defence was three-fold:

Specialty pharmacies like Philidor are legal and several drug companies have them.

Even if what Philidor did was illegal we are not responsible for them. Valeant argued they don't own them, don't appoint the CEO and are not in control. Besides Valeant are indemnified by them for any losses anyway.

Even if there is a problem here Philidor is a low-single digit percentage share of our sales and hence it won't cause us much grief.

I think all stages of this defence are questionable: Philidor may well cause Valeant to collapse. Indeed I think that likely and my price target for Valeant is zero. At the peak the debt market is factoring in a default probability for Valeant of almost 50 percent in the next five years (link). They are I think underestimating the problems. Obviously the equity market has a very different idea.I am going to lay out the evidence in this post as we currently know it. Some of this comes from the work of Bronte and some is poached from other sources, including Roddy Boyd and SIRF, the WSJ, Propublica.

In Part 1 I detail what is a specialty pharmacy and why both drug companies and customers and doctors might like them and insurance companies hate them. I also discuss the sort of infractions they might commit and the lines that separate criminal activity from merely aggressive business practice.In Part 2 I go through the evidence that Philidor might be on the wrong side of that line.In Part 3 I discuss the separation between Philidor and Valeant - a separation I believe is questionable. Some of the evidence comes from our own research, some from the call and some from some excellent work done by the WSJ.In Part 4 I detail the size of Valeant's non-traditional distribution models and how we might scale them. This produces data contrary to the data in the conference call. The scope of non traditional distribution at Valeant is much larger than bulls believe.In Part 5 I detail how Philidor may be used to fake Valeant's accounts. I don't think this is Philidor's main purpose but it clearly is an issue and Mike Pearson (Valeant's CEO) did not answer a very precise question on this in the conference call.After that there will be a brief summary.

Part 1: Describing the specialty pharmacy business - the good, the bad, the legal and the illegal

A specialty pharmacy is a pharmacy (usually but not necessarily) tied to a manufacturer which specialised in distributing classes of branded drugs. They are usually mail-order operations and operate over State lines. To operate they usually require a license in every State which they service.There are several features of these pharmacies which are are common to most but not all of these.

They specialise in branded drugs - and they offer the customer as smooth as possible a way to get reimbursed on those drugs. They generally offer excellent customer service. The customer normally discloses all their insurance details and pays a copayment. The refund claim is administered by the speciality pharmacy. In this case the specialty pharmacy or more likely the drug company bear the risk that the product will not get reimbursed. Customers do not need to deal with their insurance companies - a great advantage for some particularly if you are sick. Sometimes the copayment is waived or copay cards are administered. [If you unaware as to what copay card is look at this example from Jublia.]

Because they are captured by the branded drug distributors they are very loathe to suggest cheaper generics. A typical example is a Valeant product called Onexton - an acne cream. Onexton is a mix of two well known treatments for acne - clindamycin phosphate and benzoyl peroxide. Both these products are available as generics at low cost. However the combination has a price of $478 per tube. If you went to your local pharmacy they would (if they were competent and unbiased) suggest you buy the two generics. However if you go to the captive specialty pharmacy you will be sold the expensive drug (and the cost will largely be borne by your insurance company).

Specialty pharmacies are often very willing to waive copays and other charges to sell the drug. To put it mildly Valeant would be more interested receiving hundreds of dollars a tube for Onexton than actually collecting the copay. This is not limited to Valeant.

As a general rule specialty pharmacies are liked by patients and doctors. This is not surprising. If you want the active ingredients in Onexton you can buy the generics ($10-$15 each) and mix them and you will be out-of-pocket. Or you can go to Philidor, have them waive the copay and you will get them for nothing. And there is little to sort out. The specialty pharmacy covers the insurance claims.

Valeant made a big deal of the quality of the service at the speciality pharmacies in their call. This is consistent with most (but not all) of the discussion on consumer chat boards.

The problem of course is that insurance companies dislike specialty pharmacies. Again to go back to Onexton it is unlikely you could sustainably sell a combination of two generics at any price near $400 without insurance. A captive specialty pharmacy makes it easier to stick the bill to the insurance company. After all using two generics will have the same effect for very little money indeed.

Specialty pharmacy legalities

Specialty pharmacies are legal. Several drug companies (including most in the dermatology space) have close relationships with specialty pharmacy. They are darn useful in the case of difficult chronic diseases with cocktails of expensive drugs (such as HIV). A specialty pharmacy will know more about the cocktail of prescribed drugs and will get them couriered to you as needed.Alas specialty pharmacies are also the easiest way to get someone to pay $400 for your branded skin cream containing only generic ingredients. That someone is an insurance company and the product is a rip-off.Valeant spent considerable time in the conference call listing specialty pharmacies tied to other large pharmaceutical firms. They are legal.

Examples of infractions at specialty pharmacy - the illegal

The most important thing a specialty pharmacy must not do is waive copays for Medicare, Medicaid or other government pharmaceutical insurance schemes. The government regards this as fraud against the government. One way of ensuring that everyone goes to prison is to systematically defraud Uncle Sam.

I have no evidence that that is happening at Philidor/Valeant. Every Valeant copay assistance advert for instance specifically says that copay assistance is not available on Medicare or similar programs. This example for Onextin is instructive. It offers a zero copayment (and a coupon for your local pharmacy) but the coupon is not valid for Government programs.The government tends to be more forgiving of one-off instances of waiving copayments for Medicare. [Big fines but not prison.] Systematically defrauding the US Government is however unwise. One-off instances can happen accidentally: sometimes patients will misrepresent their own insurance position and sometimes processes to ensure no copayment waiver happens are slightly sloppy.That said - even waiving copayments for private insurance have sometimes been held to be breach of contract. There is a reasonable legal summary here. To quote:

Private insurers and the courts are not generally alarmed by occasional accommodations for individual patients with documented financial limitations. However, insurance carriers have successfully challenged the routine waiver of copayment obligations in the courts on numerous occasions.

Courts dealing with challenges to discounts of copayment obligations have been concerned with two basic issues. First, a provider who discounts established fees for some patients but not others, without a valid distinction for the differing treatment, can be subject to claims of false billing by a party not receiving the discount or consideration, including claims by insurance carriers. Second, the routine waiver of patient copayment amounts can be viewed as breach of contract. Almost without exception, insurers impose a contractual duty on providers to make a reasonable effort to collect applicable copayment amounts from patients, and benefits are only available when the charge for the service submitted by the provider is the actual, and the usual, reasonable and customary charge (URC). The reasoning in these cases is that the uniform discounting or waiver of patients’ copayment portion of a provider’s fee evidences that the provider really only intends to collect that portion of the fee which is not discounted, making it improper to claim that the fee is the full undiscounted fee.

There are other things that specialty pharmacies do that are illegal (even criminal). Perhaps the most notable is misrepresent diseases to insurance companies. To pick an example from another stock, Insys sells Subsys - a branded version of Fentanyl - a very strong narcotic. Fentanyl is approved for pain relief for some terminal cancer patients. Here is a court case where a registered nurse prescribed Fentanyl off-label (and her plea regarding narcotics distribution) but it is possible the attached speciality pharmacy (and not the doctor/nurse) falsely submitted claims to stating the patient had cancer when they did not. [Indeed this is what the prosecutor says in the plea arrangement.] Misrepresenting the script to the insurance companies is fraud and is criminal.

In general misrepresenting the claim to a insurance company is fraud. However if you defraud an insurance company you may wind up in criminal court - or you could be lucky and only wind up in a civil court.Other things that a speciality pharmacy can do that are illegal is altering prescriptions so that cheaper generics can't be prescribed. If a doctor writes "dispense as written" on a script in most States it is illegal to dispense a medically identical generic. However if they do not write this the insurance company may insist on the generic. Given sales incentives (presumably with staff remunerated for getting payment from insurance companies) the incentive to write dispense as written onto scripts or to otherwise falsify doctor instructions is high. Warner Chilcott (a division of Allergan) was criminally convicted for (amongst other things) manipulating prior authorizations to induce insurance companies to pay for prescriptions of Atelvia. The fine however was not large ($125 million).Fines for infractions at specialty pharmacies are not uncommon. Generally you reward specialty pharmacies for getting the product out the door and reimbursed by insurance companies. To the extent that you use cash incentives for the speciality pharmacy for getting reimbursement the staff of the specialty pharmacy have an incentive to cheat.Whilst fines are common they are not usually ruinous. After all these are rarely systematic attempts at cheating insurance companies. A systematic attempt at cheating insurance companies will probably result in an enormous fine, criminal charges and executives in handcuffs. There were huge infractions at Arthrocare and the CEO went to prison - however they got the conviction on easier to prove channel stuffing allegations.One recent case that is probably close to settling is against Novartis. The Government sought $3.3 billion in fines (and criminal sanctions) in a kick-back case involving Medicare and specialty pharmacies. To quote the Wall Street Journal:

The U.S. is seeking as much as $3.3 billion from Novartis AG in a suit claiming the company paid kickbacks to increase sales of two prescription drugs.

The government claims a group of specialty pharmacies submitted thousands of fraud-tainted reimbursement claims to Medicare and Medicaid for the two drugs, Exjade and Myfortic. It’s seeking damages and civil fines against the drugmaker in a case set to be tried in New York in November. The U.S. disclosed the amount of its demand in a court filing Monday.

The U.S. claims Novartis referred patients to the specialty pharmacies and paid kickbacks in the form of rebates to get the pharmacies to recommend the drugs to patients and to increase sales. The scheme violated the False Claims Act and Anti-Kickback Statute, according to the government.

In this case it was a fully external speciality pharmacy owned by Express Scripts which did Novartis' dirty work. Express Scripts settled (for $60 million) and the fact that the false claims were submitted by a third party did not save Novartis. Novartis is almost certainly cooperating in this investigation and they recently raised reserves on the eventual fine (but to a number considerably lower than $3.3 billion).Insurance rejection as a more likely end-game for specialty pharmaciesSpecialty pharmacy (especially in dermatology) is often a device for getting overpriced drugs reimbursed by insurance companies. It may be legal or it may not be, depending on the practices of the pharmacy.But insurance companies fight back - especially if the pharmacy is particularly egregious. They either (a) stop paying or (b) pay an amount considerably lower than the list price of the drug.There is good reason. After all in some cases (such as Onexton) the cheaper combination is medically equivalent. And besides from the insurers point of view this is barely a customer service issue. Usually the insured has received their (overpriced) drugs from the specialty pharmacy already. There is some evidence (below) that insurers were rejecting claims from Philidor prior to the exposure by Roddy Boyd. After the Philidor scandal this will become more common and at the time of writing the wholesale rejection of claims processed by Philidor had begun.

Part II - The nature of the problems at Philidor - have they committed crimes and are insurance companies withholding payment

There is quite a lot of evidence that insurance companies are rejecting claims made by Philidor. Whether they are doing that legally or not or whether illegal actions by Philidor are prompting this rejection is not at first the issue. The issue simply is that they are rejecting payment.Anyway the various California lawsuits mentioned the use of the network of specialty pharmacies (including R&O) was to deal with insurance companies rejecting claims. The idea is that if the insurance company is wary of paying Philidor claims (say insisting on an audit of each claim) Philidor staff just use another pharmacists identification number. The insurance company may be much less likely to audit a claim made on say a retail pharmacy in California.This solution to insurance companies that were slow to pay claims was also discussed in a a recent (and fabulous) WSJ article. This relates to the period prior to the exposure of Philidor by Roddy Boyd and SIRF.

But we also have evidence to existing rejection problems given to us in the 3Q conference call. Here is a table of gross pricing action and net realised price for the dermatology business. [Remember the dermatology business is the business most dependent on specialty pharmacies.]

Note there was a weighted price increase of 14 percent an an effective price increase of 1.7 percent. The most extreme example is Atralin where the price increase was 61 percent but they did not effectively get any increase.How is possible on average to get no increase in price having raised prices 61 percent? The answer I think is that insurance companies won't pay.And why is Atralin so extreme? Well it is a branded $604.81 small tube of Vitamin A cream. And that is it.Nobody in their right mind would buy it. It gets sold only because insurers pay - and having Philidor, a tied specialty pharmacy company - rather helps in getting this done.But Atralin is just an extreme version of the need for specialty pharmacy.

Jublia is a marginally effective treatment for toenail fungus. Paint it on daily for 48 weeks and and your chance of having toenail fungus cured rises from 5 percent to 18 percent with some chance of an adverse reaction and a cost to insurance companies of more than $8000.

Solodyn is a slow release minocycline for treating acne. There are generics available.

Ziana is another combination of two generics.

I could go on. This is not the collection of drugs a company gets from fantastic R&D. Indeed R&D has never been a major attraction of owning Valeant. Its a collection of drugs you get from fantastic - or maybe sneaky - marketing.And it is the list of products that absolutely require insurers to pay because well informed consumers generally would not.After the exposure of Philidor by SIRF, the WSJ, Propublica and this blog it was only a matter of time before insurers started rejecting claims more generally. As of writing both CVS and Express Scripts (amongst the biggest pharmaceutical benefits managers) have cut off Philidor.Evidence for systematic problems at Philidor

Waiving of copaysI have no evidence that Philidor systematically waives copays for Medicare or other government funded insurance.There is strong evidence Valeant waives copays systematically over the whole private-pay business. In the 3Q conference call Mike Pearson (Valeant's CEO) said this:

Looking at history, our commitment to patient assistant programs has grown at an annual compound rate of 128% from $53 million in 2012 to approximately $1 billion we expect to spend in 2016.

This is appoximately 8% of all revenue. Copay waiving must be near ubiquitous. Since writing my first cryptic post I have received numerous stories of auto-ship refills with copayments waived. As explained above almost without exception, insurers impose a contractual duty on providers to make a reasonable effort to collect applicable copayment amounts from patients, and benefits are only available when the charge for the service submitted by the provider is the actual, and the usual, reasonable and customary charge.Philidor clearly does not do that.The lack of a California license

Any artifice that Philidor has to deliver in California is likely to be skating close to the law. Valeant in their conference call say they use a network of local pharmacies (there are an undisclosed number in the network) to deliver in states where they are not licensed. To quote:

In addition, they are exploring partnerships with independent pharmacies on a contractual basis. Under these arrangements Philidor would provide the back-end services while the partners would run the front of the store. In the future we would anticipate that Philidor's growth plans will rely much more on expanding its network via partnerships. This strategy should allow Philidor to grow faster with fewer regulatory hurdles. This model is also much less capital intensive than acquiring pharmacies...

We understand that Philidor holds nonresident licenses in 45 states, the District of Columbia and its resident license in Pennsylvania. In the few states where it is not directly licensed, such as California, Philidor does not dispense products to patients. Philidor has agreements with affiliated pharmacies that have California licenses and those pharmacies have dispensed products to patients in California.

We also learned that at least some of (and possibly all) of this "network of pharmacies" is owned through a variable interest entity [VIE] and that (until now) Philidor has not disclosed their ownership of them.

If ownership for a pharmacy changes generally this needs to be disclosed. But by using VIEs not only has Valeant disguised its ownership of its network of pharmacies. [Question for Valeant - you should also consolidate them - can you disclose the list.]

The Valeant quote above indicates that these were used to get around California licensing.

Gay Dodson, executive director of the Texas State Board of Pharmacy, said her agency would need to look into whether there was a connection between Philidor and Orbit Pharmacy, whose top official, James Fleming, is Philidor’s controller. Texas law allows people to set up corporations “as you wish,” she said, and if Philidor and Back Rank are fully separate entities, “I think we would have problems tying the two together and being able to take action with a different corporation, an entirely different corporation. We would have to really look at it.”

There is some pretty clear black-letter law in some States regarding this. Whether it is enough to sink Philidor is open to much doubt. However it will give insurance companies some grounds to sue for reimbursement or deny payment.

I think the explanation that the "network" pharmacies exist to get around licensing restrictions (an explanation given by Valeant in the conference call) is bunk. I think the real explanation is much nastier.

The likely real explanation for network pharmacies

The latest WSJ article really is a stunner. Jonathan Rockoff (the journalist) has one of those wonderful definitive documents: he claims to have a Philidor training manual. I have not seen this manual and cannot judge first-hand what it contains. However - the evidence provided by the WSJ - and on the say-so of the WSJ - would be very useful in determining whether there was systematic fraud at Philidor.If this manual tells staff how to deceive insurance companies then its a slam-dunk for systematic fraud.Moreover this is all done across state lines using mail and wires. That would be a text book wire and mail fraud against a financial institution the penalty for which is up to $1 million per instance with no limit to the number of instances.So here is what Rockoff says (and they are his sources and I have not seen the said manual).

If a health insurer wouldn’t work with Philidor Rx Services LLC, the pharmacy instructed staff to try again using the identification number of a partner pharmacy to secure payment. “We have a couple of different ‘back door’ approaches to receive payment from the insurance company,” a Philidor training manual said.

This is a scorcher of an allegation. Philidor has acquired a network of pharmacies (mostly former mum-and-pop operations). The allegation here is that if the insurance company rejects the claim originally you should just "borrow" the identification number of a "partner pharmacy" and resubmit the claim. The money quote is "we have a couple of different ‘back door’ approaches to receive payment from the insurance company". Does "back door" mean deception? If so there is a very big problem for Philidor.Moreover the article from Jonathan Rockoff confirms work done by Bronte and The Skeptic. The Skeptic's take is better than mine. We know the UPS delivery details of 21,000 prescriptions administered by Philidor but marked using R&O's pharmacy identification number. These were not just shipped to California (as asserted by Mike Pearson in the conference call) but were shipped all over the USA and to states where neither Philidor nor R&O were licensed. The Skeptic has an analysis of all 21,000 prescriptions stripping data from UPS's website.Using R&O's number to ship to states where Philidor was licensed but R&O was not looks like Philidor was shopping for a Pharmacist's number that did not prompt rejection from the insurance companies This is the allegation in the WSJ.Deceiving an insurance company as to who filled the prescription also looks like it matches the definition of mail fraud. It is an artifice to obtain money from a financial institution using mail over State lines. Philidor pretended the script came from R&O whereas it really came from Philidor.The fine in this instance - and this is just one specialty pharmacy "partner" amongst an undisclosed many would be greater than $10 billion. [It is against a financial institution and the penalty for mail fraud is a million dollars per instance and there are no limits to the number of instances. And there are more than 10,000 instances outside California where the administration was done by Philidor and the product was supposedly distributed by R&O.]Whatever: if the prosecutors wish to take this seriously (and I suspect they will) this is enough to kill Philidor. Whether it is enough to bankrupt Valeant will depend on whether Valeant can successfully defend the notion from the conference call that it is not liable for Philidor misdeeds. I don't think they can - but that is discussed below.Other possible misdeeds by PhilidorThe Wall Street Journal hints at other misdeeds by Philidor.

A separate department at Philidor would seek insurance coverage. If the insurer asked a doctor to explain why the patient needed a costlier Valeant drug rather than a less-expensive alternative, Philidor employees would sometimes fill out the paperwork for the doctor, two of the employees said.

The WSJ leaves it as ambiguous as to whether this has been done with or without approval from the doctor. With approval from the doctor is legal. Without about approval from the doctor it is criminal and that behaviour has been prosecuted in the past.Dispense as written fraudCaroline Chen at Bloomberg News is stating she has acquired written instructions from Philidor to their staff to falsify "dispense as written" and other doctor instructions on the prescription. This is an allegation of criminal behavior:

A specialty pharmacy that fills prescriptions for Valeant Pharmaceuticals International Inc. has altered doctors’ orders to wring more reimbursements out of insurers, according to former employees and an internal document.

Workers at the mail-order pharmacy, Philidor RX Services LLC, were given written instructions to change codes on prescriptions in some cases so it would appear that physicians required or patients desired Valeant’s brand-name drugs -- not less expensive generic versions -- be dispensed, the former employees said. Typically, pharmacists will sell a generic version if not precisely told to do otherwise by a “dispense as written” indication on a script. The more "dispense as written" orders, the more sales for the brand-name drugmaker.

An undated Philidor document obtained by Bloomberg provides a step-by-step guide on how to proceed when a prescription for Valeant dermatological creams and gels including Retin-A Micro and Vanos is rejected. Similar instructions for changing the DAW indication are supplied for patients who are paying in cash.

I have not seen the training manual but if this training manual exists it is evidence of systematic fraud against insurance companies.

Part III - the separation of Valeant from Philidor

Valeant went to an unusual extent to hide their relationship with Philidor.Philidor was first exposed publicly by the Southern Investigative Reporting Foundation. At this point Philidor was growing enormously fast (rising to about 1000 staff by this year end). Philidor however had a website registered to domains by proxy and no information as to ownership on Valeant's website or in any SEC filing. Moreover the California government went as far as alleging that Philidor had given false statements under penalty of perjury - seemingly to hide their ownership.The headline from the call was that terms of the options involved and whether they do or don't "own" Philidor.If you want a quirky take on it Matt Levine is clever as usual.But in the presentation we discovered deniability had been built into the Philidor arrangements from inception.

Valeant says that they paid $100 million up front for an option to acquire Philidor at no consideration any time in the next ten years. They also are liable for milestone payments of up to $133 million.This is a strange asset. Valeant can acquire Philidor for no consideration - but they seem not to own it. This is a sort of limbo: ownership but not ownership. This left Valeant with a very difficult line to thread which was to argue that they gave $100 million to something they did not control but they were not financially reckless. [We don't control them but look at all these controls we have over them.]Remarkably many accepted this rhetorical stunt.The line of the conference call came from Valeant CEO Mike Pearson:

In terms of the zero dollar option value, I think it is legal and maybe it's unusual.

Mike Pearson thinks it is legal and knows it is unusual.There were some prior indication of Philidor's existence. This is- from the 2015Q2 conference call is probably the strongest:

David Steinberg - Jefferies LLC - Analyst

Just wanted to follow-up on the Jublia question. You mentioned the change in the gross to nets, but did the -- especially, did the number of scrips going through the specialty pharmacy improve? I think it was about 50% last time. Secondly, given the strength in some of your other derm products, Onexton and Luzu, what percent of those scrips are through your specialty pharmacy channels?

Yes, the adoption through multiple specialty pharmacies continues. I think last time we said Jublia was around 50%. That trend continues. For derm overall, it varies by product, but it's around 40%.

And here we discovered that that for dermatology products specialty pharmacies were very important and the analyst thought that it was likely to be particularly important for Onexton and Luzu. We saw above why it would be particularly important with Onexton. Luzu like Onexton also has generic alternatives and would require insurance to get people to pay the high sticker price.Even when asked directly Valeant did not reveal it "owned" its main specialty pharmacy.Did Valeant need to disclose the ownership of Philidor and why did they hide it so thoroughly?The short answer is Valeant probably didn't need to disclose Philidor but that hiding it was unusual. Here is the critical slide.

The observation was that Philidor - a $100 million option with cumulative net-sales was not material and therefore did not need to be disclosed.I am not going to argue with their legal advice with respect to this. Mike Pearson "thinks" it is legal (as quoted above). However I will observe that Valeant does not always hide their acquisitions. During the same quarter (the fourth quarter of 2014) Valeant disclosed acquisitions down to $20 million in value. [Size of deal here, and one of many disclosures as to the acquisition here. This was one of many similarly small disclosed acquisitions.]Moreover the list of subsidiaries Valeant has goes to subsidiaries much smaller than Philidor. For instance the attached list from the 10-K has tiny little subsidiaries - multiple subsidiaries - each with one corporate jet. But it does not mention Philidor. Philidor also met the definition of a subsidiary within Valeant's bank covenants - but I am not sure whether this obliged them to disclose them in SEC filings or only to the banks.Hiding Philidor made me think prima-facie the company is doing something wrong at Philidor.The company has an alternative explanation: they hid it because it was a competitive advantage.Notwithstanding this Valeant has gone to lengths to legally distance itself from Philidor suggesting that they were aware there was a possibility that they were doing something wrong.In the conference call they said they were

indemnified by Philidor and

able to walk away entirely.

Both those assertions are questionable. But these suggestions make it clear they were aware of the possibility of legal problems.Agency fraudWhilst Valeant has made a great deal of effort to legally separate itself from Philidor there are plenty of circumstances where such a separation will not stick.Above I mentioned a case where Novartis is facing criminal charges (and a $3.3 billion fine) because of actions by its specialty pharmacy. In this case the specialty pharmacy is owned by Express Scripts. It is clearly legally separate.The reason that Novartis is (potentially) liable for the actions of Express Scripts is that the incentives that Novartis gave Express Script induced the fraud and they were either reckless or knowing as to this inducement.The issue is simple: was Valeant or senior members of staff complicit in crimes at Philidor? If so then nothing much will save Valeant.Again the WSJ offers some fantastic colour. They indicate that senior staff at Philidor were in fact staff of Valeant acting under (mostly silly) false names. To quote:

Around the Phoenix-area offices of mail-order pharmacy Philidor Rx Services LLC, employees said they often ran into a friendly colleague named Bijal Patel who tracked prescriptions. But when the employees got an email from the colleague, they say he used a different name: Peter Parker, the alter ego of Spider-Man.

He was among a few workers at Philidor offices who went by one name in person and another in emails during the past two years, according to three former employees. Mr. Patel and the other people weren’t employed by Philidor, though the emails used a Philidor address, these people said. They were employees of drug company Valeant Pharmaceuticals International Inc.

As late as Sunday afternoon, the LinkedIn page for a man named Bijal Patel identified him as manager of access solutions at Valeant in Scottsdale, Ariz. Mr. Patel didn’t respond to requests for comment.

The Valeant employees were placed at Philidor while the pharmacy was in its infancy, to provide help on “structures and processes,” said a Philidor spokeswoman. She said in a statement that the Valeant employees set up separate Philidor email accounts, under “clearly distinguishable names,” to keep “their internal Philidor communications separate from the Valeant communications, primarily to reduce the risk of incorrectly sharing either company’s proprietary information.”

Bluntly senior employees of Philidor were in fact Valeant employees but were obscuring that tie by using the names of Peter Parker and other super-heroes. The Valeant employees (plural) set up "structures and processes".This is going to be impossible to keep separate.Further we know that Valeant rewarded its own staff for helping Philidor. Here is a corporate award to a Valeant sales staff member who "helped set up Philidor in six States".

This is consistent with the WSJ article that Valeant employees were involved in setting up Philidor.Valeant made a big show in the conference call how they have an indemnity from Philidor. There is of course a likelihood that Philidor can't pay. After all it is only a mail order pharmacy (and it is hard to identify huge quantities of assets that can be turned into hard cash in a crisis). However as Philidor is consolidated into Valeant recovering from Philidor would have a limited effect on the GAAP accounts. [Contra: I guess Valeant could abandon Philidor, take the charge and then sue Philidor. However Philidor would have little business without Valeant so this is moot.]

Part IV - the size of Philidor and the specialty pharmacy channel

The specialty pharmacy channel is very important in dermatology in America. Above I quoted the second quarter conference call where they put the specialty pharmacy channel (including but not limited to Philidor) at 40 percent of sales and 50 percent of Jublia sales.In the conference call however they downplayed this. They did not give the numbers versus dermatology - but rather against the whole business. Here is a typical slide:

To regular Valeant watchers this slide came as a shock. It downplayed the importance of Valeant's alternative distribution channels.Only a year ago Valeant was telling us how big and important their alternative distribution was. If you remember Valeant was having the huge spat with Allergan. Allergan were saying Valeant's sales were falling and Valeant was saying that they were growing.Allergan was using IMS data which is a standard data source in pharmaceuticals. Valeant stated outright that their sales were not falling and that the IMS data did not cover the bulk of their sales due to reliance on channels such as specialty pharmacy.This critical text is here (and the source is here).

Now these slides were made when Philidor was much smaller than its current size and even then more than 100 percent of the growth of many of the business lines of Valeant came from specialty pharmacy and other non-traditional distribution channels. Net of non-traditional channels Valeant's sales were falling (Allergan was not misrepresenting the IMS data). Inclusive of non-traditional channels Valeant claimed their sales were rising.Moreover we now know that Valeant has relationships with other specialty pharmacies. It also has a network of pharmacies that it may or may not be including in the Philidor numbers. [Honestly I don't know - the disclosure here is very poor.]The changing scope of PhilidorOne observation that had me wondering was the changing scope of Philidor between the 3Q conference call and the special conference call.In the 3Q conference call this is what Mike Pearson (Valeant's CEO) said:

Philidor, one of our specialty pharmacy partners, provides prescription services to patients across the country, and provides administrative services for our copay cards and is a dispensary that fills prescriptions. We have a contractual relationship with Philidor, and late last year we purchased an option to acquire Philidor if we so choose.

Specifically Philidor is one of several specialty pharmacy partners [which fits with observations above], dispensed scripts across the country [for which we know it is not licensed] and "provides administrative services for our copay cards".The administrative services for copay cards function had entirely disappeared by the special conference call. This is the key slide:

At no point does it say that Philidor administers Valeant's copay cards. Maybe the first conference call misspoke - but administration of the copay card is a core function.Moreover the copay card program is critical to Valeant's relationship with other specialty pharmacies. If Philidor acts abusively then the entire non-traditional channel for Valeant is probably tainted.I would really like to understand whether Philidor really does administer Valeant's copay system generally (and how that is run) or whether Mike Pearson misspoke in the 3Q conference call.

Part V: How Philidor could be used to fake Valeant's accounts

Since Philidor is consolidated into Valeant it cannot be used to fake Valeant's accounts by channel stuffing. Citron's core allegation is incorrect.However there are other things that can be done.As stated above Valeant is liable for up to $133 million of "milestone" payments (presumably if Philidor meets sales targets". These milestone payments would of course be capitalised into the cost of buying Philidor - but you could alternatively describe them as "sales support expense" in which case they should be deducted in the P&L statement.There was an explicit question about this in the conference call and Mike Pearson did not provide a real answer. Here is the exchange:

David Common - JPMorgan - Analyst

Yes. Thank you very much for taking a fixed income question.

I wondered if you could tell us who got the $100 million and the potential $133 million in milestone payments. Is that basically money that is used by Philidor to stand the Company up? I wonder if the consideration really needs to be zero dollars for the purchase option. I normally think of some consideration to make that transaction legal...

In terms of who received the money for the $100 million up front plus the first milestone payment, my understanding is that there are a number of equity owners. I think it's between 10 and 20, maybe more. And they would be whoever owns the equity of Philidor would've received the money.

And whether those individuals decided to contribute money into the operation I have no clue. I just know that we have not contributed any money into the operation. In terms of the zero dollar option value, I think it is legal and maybe it's unusual.

The answer to the question was "I don't have a clue".We know however that Philidor was linked to Valeant from inception. The WSJ reported:

The Valeant employees were placed at Philidor while the pharmacy was in its infancy, to provide help on “structures and processes,” said a Philidor spokeswoman. She said in a statement that the Valeant employees set up separate Philidor email accounts, under “clearly distinguishable names,” to keep “their internal Philidor communications separate from the Valeant communications, primarily to reduce the risk of incorrectly sharing either company’s proprietary information.”

Now we know (from above) that Valeant provided support for establishing Philidor and that several Valeant staff work at Philidor (using names borrowed from comic books).But Valeant paid $100 million for what was essentially a startup they founded. And they pay progress payments too.If that is a capital expenditure it is a bizarre one. Valeant provided critical support for setting it up and after doing that they buy it.The alternative in part is the $100 million was used to run Philidor and the $133 million of milestone payments also cover Philidor expense.But in that case they should be expensed.I guess this is something for the Ad Hoc Committee of the board to work out.Effect of the consolidation of PhilidorPhilidor can't be used for channel stuffing now but it could be used for channel stuffing before acquisition.If it had been used for channel stuffing before acquisition then pre-acquisition Philidor would have owed a great deal of money (for inventory) to Valeant.When it was acquired that internal loan would be cancelled and the consideration would have been added to goodwill.That is a wonderful fraud and is in fact how Lernout & Hauspie (a very famous fraud) faked its accounts. Essentially fake earnings from stuffing Philidor would be turned into fake receivables - and then the receivables will be cancelled and turned into (unauditable) goodwill. I hope the accountants have covered base for this possibility.The tell in the accounts would be a strange drop in receivables at the end of the 4Q of 2014. Alas Philidor was small relative to Valeant (then) and so it is not certain that this change would happen.The evidence is against Valeant having committed this fraud. The trade receivables rose between 3Q and 4Q 2014.In general I agree with the proposition in the conference call that Philidor has not been used to fake Valeant's accounts - although Michael Pearson's answer to a pretty direct question was disconcerting. He doesn't have a clue...

Summary

Citron's report into Valeant was easy to dismiss. Citron argued that Valeant used the undisclosed relationship with Philidor to goose the accounts through channel stuffing.Valeant did a good job dismissing that though in the conclusion we learn there are some minor accounting issues with Philidor.The more pertinent question though is whether(a). Philidor is a device to systematically defraud insurance companies(b). Whether the legal separation from Philidor is sufficient to immunise Valeant from liabilities and(c). Whether this is big enough in Valeant to cause very adverse impacts on Valeant equity and debt holders.The evidence is very strong for (a) and most the evidence has been provided by the Wall Street Journal. Insurance companies are taking no chances: several big companies are now no longer reimbursing claims submitted by Philidor.It is very unlikely that the separation between Philidor and Valeant (as per question (b)) is sufficient to protect Valeant from liability. They appear to be joined at the hip with Valeant providing senior staff (who work under false names) and Valeant providing much advice when establishing Philidor.Whether the Philidor problems are sufficient to cause major pain to shareholders (even bankruptcy) is unclear. Philidor itself is a high single-digit percentage of Valeant's sales (but it critical to the dermatology franchise). However Phildor also may administer the copay cards and they are critical to quite a lot of Valeant's business. Non traditional distribution is the difference between a shrinking Valeant (as per the IMS data) and Valeants assertion that it is growing.I am intrigued as to how this plays out.

Doesn't this sort of stuff gets settled all the time between companies? These insurance companies are not the government in a witch hunt or trying to make an example out of a company, they are most likely be happy with a fat settlement than try to take down an entire company

The thing is, the insurance companies would have to win two suits, the fraud suit and the 'Valent is liable' suit. I'm not a experienced lawyer but it seems to me this unusual situation would increase the incentive to settle instead of hoping for a double win for a bigger payday

I expect that Valeant, as a publicly traded company with responsibility to its shareholders, will attempt to obtain the $100mm and $33mm from Philidor's owners rather than write it off as a 'failed investment'.

Given that the entire exercise has been right out of the playbook of Medicis' "access" business, I hope that some manner of investigation will continue.

There is also another issue here. Any fine that could potentially flow through VRX will only come out after, likely, years of litigation (specially that its 2 suits that need to be won). The balance sheet (and liquidity) that matters is VRX in a few years, not the one that exists right now

I don’t see any evidence here that Valeant (as opposed to Philidor) has done anything illegal. If Valeant had been paying kickbacks to doctors for sending patients to Philidor then that would be a big problem. But no sign of anything like that. Valeant presumably pays Philidor commission on sales, but that’s just normal business practice. If Philidor has been illegally generating extra sales to earn more commission it’s not Valeant’s fault in any legal sense. The Valeant employees at Philidor can be explained as being part of the joint steering committee.

Your Part IV requires us to believe that the Valeant CEO was simply lying when he said that speciality pharmacies only account for 7.2% of revenue YTD. (And the other management and board members who went along with the lie are all hopelessly corrupt.) Because otherwise what you wrote there has no teeth.

Your disputing of Valeant's claim that it is not liable for Philidor requires us to believe that their lawyers are incompetent…

Probably Philidor will quickly collapse now. Then Valeant can buy up their assets, rehire their staff (except the corrupt management), rename the company and continue the specialty pharmacy operation as before, minus the overly aggressive/illegal parts. The revenue from it will no doubt be reduced, but the impact of that on the overall business is very limited.

@Global: sure, possibly. But how many fat settlements can a company with loads of debt afford? Do the changes that may be required hit its margins and cash flow, further reducing its ability to afford settlements? When do they overwhelm the business?

What numbers of new cash settlements required plus reduction in margins or cash flow kill the company? If the revenues start dropping, is it still viable?

I notice in the news articles that although Valeant says they're severing ties with the company, it seems Philidor will just be shut down. Meaning no meaningful business there apart from Valeant. Presumably all of their other specialty pharma channels will be under severe scrutiny as well.

Channel stuffing generally isn't fraudulent (I think); it's just postponing a profit warning. There is a definitional difference between Valeant selling product to Philidor, or indeed another 'channel', vs. selling out of the channel to the eventual consumer with respect to channel stuffing. However, from an investment point of view, I don't see a strong difference between the channel being stuffed and the consumer/patient being stuffed.

I can't remember whether it was you or Citron or SIRF that had that quote from someone saying that thanks to unrequested refills they now had enough cream to treat 200 years' worth of athlete's foot, but here's the critical point: that guy never needs any more foot ointment so Valeant's sales are going down. Maybe the channel stuffing allegation IS narrowly incorrect, but the short is very much on because the consumer is stuffed.

I think the bigger point John is trying to make, is that the lines of business that made Valeant so profitable, will be drastically cut back. Given these lines seemingly huge margins, it may have a much greater effect on the bottom line than their % of total revenues indicates. In tandem w/ the earlier scrutiny on the price increases across all their products and the huge debt load requiring interest payments, the profitability of the company could be greatly diminished. Possibly to the extent that the viability of the company comes into question, and at the very least the growth story is kaput.

In addition, because Valeant isn't a "pharmaceutical SIFI" and has attracted so much attention and involves a huge cast of characters, the regulators may use it as there poster-boy/head-on-a-stick. Especially since John has succinctly laid out the road-map for them.

Sorry John but the ackman slide showing the settlements has destroyed your short thesis. There is simply no basis for you to believe there will be a huge bankrupcy leading fine into these suits. Companies that did shit worse then phillidor walking away with settlements that VRX could pay with 1 or 2 month worth of cash earnings. You better do some more digging because yelling fire about that over and over again won't work anymore

Regarding the Valeant employees working at Philidor, it sounds like they were sent there in consulting roles. (Probably not actual members of the steering committee like I suggested earlier, but sent there as a result of decisions by that committee).

If a consulting firm sends some of its employees to work at a company as part of a contract, are they liable if the company commits wrongdoing while the consultants are there? Presumably not, unless the consultants were involved in instigating and/or perpetrating the wrongdoing.

Then the key question is: were (or can it be shown that) the Valeant employees at Philidor were knowingly involved in the wrongdoing that took place there? I don't see any evidence of that from what has been presented so far.

"At no point does it say that Philidor administers Valeant's copay cards. Maybe the first conference call misspoke - but administration of the copay card is a core function. Moreover the copay card program is critical to Valeant's relationship with other specialty pharmacies"

Valeant’s initial premise is everyone else in pharma is a scumbag but gets away with slaps on the wrist. Their business strategy is just to play the same games as everyone else but in a smarter way and not to be a sucker and do R&D and pay taxes.

It is true that the industry does a lot of really reprehensible things in the sales and marketing of both drugs that are life-saving and drugs that are maybe even life-threatening. A lot of people give them free-ish passes for this behavior. What Valeant has failed to understand, however, is that these free passes are not really free. The cost is paying taxes and doing / funding actual R&D.

In reality, anyone who thinks they have found an arbitrage that no one else has discovered in as large a market as pharmaceutical drugs, is the real sucker.

I’ve started an analysis of Valeant’s top 30 products. From what I can tell, they have two “brilliant ideas”. The first, which applies to the hard contact lens business, is to buy up all the suppliers of a reasonably small market, get monopoly control and then jack the prices. Unfortunately, the plot to keep a low profile while appearing to clearly violate anti-trust laws and avoid regulators appears to have failed.

The second strategy is to buy the old, small but important drug and jack the price. This Isuprel and Nitropress. This also is a self-limiting strategy because if your profits get over a certain level, someone else will enter the market. And even if they don’t, there is a good chance that Congress will make your life hell and change the rules to screw you. Bill Ackman’s defense of Valeant was that they screwed up by not spending more time in DC lobbying. He fails to understand that if you do not pay any taxes and do not do R&D and aren’t outwardly bribing people, your pleas for mercy will fall on deaf ears. The only benefit that Valeant has claimed is copious amounts of “patient assistance”, which is just a way to window dress massive price discrimination.

The third and most important strategy is to con insurance companies into paying for things they are trying not to pay for. In economics, we would call this a “principal-agent” problem. In finance, we call it OPM (“Other People’s Money”). Insurance companies and the government see co-pays as an important way to nudge people into making decisions as if they were spending their own money. It turns out that people are ridiculously sensitive to out of pocket costs. Give a 10 cents credit for bringing your own bag - 10% of people will play along. Charge 10 cents for a bag - 90% of people will bring their own. For realsies.

There is a remarkable amount of collateral on the web from marketing companies that have worked with Valeant to help sell their drugs. They explicitly discuss using tactics based “behavioral economic” research to lower the barriers to customers buying the over-priced brand name drug. Mostly this includes eliminating co-pays for people whose insurance company is either asleep at the wheel (the “burnouts”) or who thinks (mistakenly) that no patient will buy the drug because the patient will have a huge co-pay. Virtually every drug that Valeant has that shows large increases in sales is increasingly being sold with some kind co-pay elimination strategy. In order to make this as seamless as possible for the customer, Valeant ends up selling some drugs at $35 - $75 month to patients. They probably still make money on this and can show an increase in volume. If they are not making enough money, they can simply not be very aggressive with auto-refills. I would be shocked if it does not come out that Philidor had different policies for auto-refills for well-insured patients vs self-pay ones.

Valeant pursued this strategy through multiple different channels. First, they used programs like McKesson’s Loyaltyscript, where a pharmacist first puts through the prescription to the real insurance and then submits a second “insurance” claim for the co-pay amount. This is not really insurance - this is functionally just a write off of part of the outrageous price because the 50% they get from the insurance company is still a ton of money.

Then they used “specialty pharmacies” that are really just marketing agencies like Direct Success that have added pharmacy capabilities to cover the legal niceties.

The problem is that the large insurers and payers are not actually down with this. Through lawsuits and adjustments in payment agreements, they make it harder and harder to extract OPM.

Thus, we get to the most extreme application of this strategy in the form of Philidor, where it is an all-out battle to trick insurance companies into paying.

As this article has pointed out, this strategy is self-limiting. You may break the law or just goad payors and lawmakers into making rules changes so that the effort and cost don’t make sense any longer.

At this point, Valeant’s only strategy is to get the other pharmaceutical companies to decide that their profits are at risk if probes into Valeant continue. This is why you will Valeant and their large investors continue to emphasize that “everyone else is doing it too”. It will be interesting to see whether pharma decides that sinking Valeant fast or supporting Valeant is their best move.

Here is a google spreadsheet [http://tinyurl.com/valeantdrugs} that I put together from my couch last night, along with various documents in a google folder about their sales strategy [http://tinyurl.com/valeantdocs]. I took the top 30 products that Valeant finally disclosed in their earnings presentation this quarter. [Sidenote: the lack of disclosure in SEC documents is truly stunning]. I looked at year over year growth, both in absolute dollars and percentage increase. For every product that Valeant said was impacted by currency, I assumed this meant that the product had meaningful international sales.

Product by product, I’ve started going through the sales channels. With a handful of exceptions, the products driving revenue growth and profits seem heavily reliant on co-pay elimination strategies. The insurers, large payers and the states will crack down on this - and Valeant is dead. Other companies may be doing some of the same stuff, but they are not doing it everywhere and all the time. They also have “get out of jail free” cards because some of them are stupid enough to pay taxes.

Team Valeant keeps talking about what a small percentage all of this is. As far as I can tell, Valeant has a part of the business that probably doesn’t make much money but provides cover for the absurd profits they are getting selling zit cream. In isolation, many of the statements they make are mathematically correct but meaningless when the full scope of this enterprise is understood.

The real question is how much the real franchises can be sold for, once reverse the no-tax bonus and add back in costs for the gutted staff.

Disclosure: small short position, trying to figure out whether to take profits or hold onto the bitter end

The assertions in Valeant's recent conference call that it doesn't own or control Philidor while at the same time referencing the varying ways it controls Philidor (Joint Steering Committee, ability to dictate hires, etc.) seems analogous to the tensions between classifying workers as employees vs. independent contractors at Uber, et al.

I'm curious as to the interplay between agency law and the indemnity provisions Valeant highlighted. It isn't as if an employee can indemnify her employer for actions taken in the scope of her employment.

It seems that the biggest danger is not regulatory fines... but rather payor response.

VRX's business model relies on scamming payors by waiving co-pays or altering scripts. If payors successfully pushes back against such practices, VRX would have to see price pressure, which falls straight to the bottom line.

Heck, John, if you really have some balls you would be longing the stock now and admitting the mistake. I just can't see how anyone who analyzes companies for a living can remain short after those slides. The long case has a huge reward to risk ratio. The short case has nothing. Like literally, there is nothing behind it other than a one time london whale stlyle charge that is meaningless for the long-term value of the company. The whole thing has taken proportions that got totally ridiculous

In early Sept of 2015 Philidor employees were told to tell "patients" that called that the copay cards were no longer valid. That the courtesy $0 copay was applied ito their first"fill". This was a change as prior to this time "PCA's" were told that it was OK to tell "patients" that meds/prescriptions that did not have a $0 copay for their intial fill could use the cards to fill their "second" fill. Many cards had multiple fills. The clue was whether the card started w/ a five(5). For example, copay card 50777178 as their ID would give you the option of 6fills of onexton or 3 of Ziana, 3 of Atralin or 3 of Retin-Micro .08%.%0776939 would give you 12 fills of Jublia and 1 of Luzu.This change came as the outbound program/autfill program came to the fore. In this program "patients" were called by phone and told if they did not return the call w/in 24 hrs the medication would be sent. A courtesy copay card was used to eliminate their coopay. An examination of many of these "patients"likely show that one of these multiple cards was used across different "patients" to give them a $0 copay. The program was only good for as many fills as the original script. It is also likely that even if the "patient" called in to suspend the med they were held for 30 days, the length of time before a new "fill" could be filled, and then given another call. Remember by this time Philidor had established which insurances "paid" for the meds. The more the the insurance co paid the more likely those patients were targeted for auto fills

Check the copay cards issued to the doctors. Look to see if they were applied to "patients" in the outbound/auto refill program after Sep '15 across multiple patients. you're looking for ID's 50777178, 50776939. The former is for multiple's of Onexton or lesser amounts of Ziana, Atralin or Retin-A Micro 0/.08%. The latter for Jublia/ Luzu. At this time "PCA's" were told that anyone calling and holding copay cards could not use them for refills event though prior to this time they could be applied for second "fills" even if the first "fill" was a $0 copay and refills were currently $40. Give Sus DiCicco Brignoli to have her explain how the doctors were told to use the cards.

Valeant is like Duke/Enron/et all during the California Energy Crisis. They don't need to invest more in lobbying, they need to get a better business model. Pissing people off isn't a good one: some of those people are regulators and politicians. What has been will be again, what has been done will be done again; there is nothing new under the sun.

Philidor probably had a nominal pre-money valuation of $1 million or so.

Valeant then bought an "option" to acquire the existing share interest in Philidor plus 99x addition shares for $100 million.

The beneficial owners of the first $1 million were the Davenports and their lawyers. The other $99 million became working capital at Philidor. 1,000 employees would consume $50-150 million/year depending on rent, pay, expenses, etc.

I am just speculating of course, trying to figure out what the legalese must have looked like.

In short, I am agreeing with your notion that it was really SG&A expense (Stuffing, Gouging, and Anonymizing). But the corporate documents were probably tortured so that the money appeared to be a purchase of an addition share stake.

And with regards to growth concerns, I think that is irrelevant with the stock trading where it is. You remove the enron and the huge fine scenarion off the table (and Ackman did that) then the stock will reprice to something closer to $140 a share. Right now its a buy based simply on the valuation even if growth sucks. Short-term, of course, anything can happen and momentum is driving everything. But looking at 6 months out it will be hard for the stock to stay where it is

Really nice work John. I always really look forward to all your blog posts - even though I am an ETF investor.

It's no wonder that the US healthcare system is one of the most expensive on a per capita basis and gets comparatively poorer outcomes with clear vitamin creams being branded up to many hundreds of dollars.

I work in Aerospace & Defense. One of my many duties involves dealing with government auditors. Friday, the auditors asked whether our health plans pay for Valeant drugs. I'm not sure how to answer that loaded question. The answer is yes, currently, but the auditors will want a more comprehensive response which relieves the government of potential embarrassment for reimbursing expenses paid to crooks. It looks to me that we will have to have to redesign our PBM's formulary. I can't say that breaks my heart, but it sure is a pain in the ass.

Put yourself in my position. I have to defend Valeant's price gouging in audits of actual costs while simultaneously telling the government that we contain costs in every way. Guess who we will be throwing under the bus with prescription drug benefit design changes effective 1/1/2016?

One issue I haven't seen discussed anywhere is Valeant/Philidor incentivising the prescribing doctors. Given everything Philidor was doing to squeeze money out of insurance payers after they got hold of a prescription, surely they were not just sitting back and hoping doctors would prescribe their very expensive but not very effective medicines. All of the patient anecdotes say that the doctor pushed them towards Philidor.

I believe the FDA has strict rules about what pharma reps can say to doctors about their drugs and presumably they have rules against paying doctors as well. If there was an envelope to be pushed and laws to be broken there then no doubt Valeant was pushing and breaking.

@Anonymous 5:46 PM - The highly coveted B+ rating is only for creditors who have secured debt. The Valeant corporate credit rating is B-. Suppliers will have to closely monitor their receivables and credit extension policies.

Great analysis you can see the commitment and hard work which pays of for the investors at Bronte Capital that are doing a lot better than investors at Pershing. I like more John analysis than ACKMAN unrealistuc slides ! I wonder if any employees of Valeant that worked directly with Philidor that is terrified of.possible legal consewuences is ready to cooperate with authorities for reduced sentences in case there are wrong doings which I'm not sure. I wonder if Medicare was part of any wrong doings by accident or in purpose. I wonder how the 4th quarter earnings will look ? Why VRX hasn't issued a SEC statement regarding the whole fiasco affecting 4th qtr earnings and 2015 earnings. I think Michael Person could resign soon? Why is Pearson hiding, I have not heard a word from him or from the biased Ad Hoc which I don't trust because they have shares and want to recover! Another mind boggling question is why the regulating entity in Canada has been so silent maybe it takes a long time to start investigations but this is the most important case that I know they had in years ! Thank you for the hard work John! Do you think Valeant has done any.shady business in Latin Amrica?

I am going to suggest that this goes deeper, and affects more sales and sales growth than one thinks it does.I will also suggest that it affects more Reps, and more doctors' willingness to prescribe Valeant/Medicis drugs. If it is "good for patients" then that was a reason to overlook stupid pricing and go for the zero-dollar co-pay rather than the $20 generic.

If this causes a big picture re-think about a requirement to use generics where possible, then I think companies like Valeant will have a much harder time of it going forward.

"Like literally, there is nothing behind it other than a one time london whale stlyle charge that is meaningless for the long-term value of the company. "

You are not getting it mate. The real issue here is that Valeant has expanded very rapidly, financed by debt. The debt service is, in general, covered by the cash flows generated by the businesses as-was-when-acquired. The equity cash flows are dependent on sustaining higher margins.

If it turns out that "sustaining higher margins" means "carrying out systematic dispense-as-written and similar fraud", then the equity cash flows aren't there. Even if there's no legal liability getting back to Valeant, the simple fact of the insurance companies getting their act together to defend themselves is hugely damaging. If the insurance companies also decide to scapegoat Valeant to make an example of what happens to people who try to screw them, the volumes could go south at the same time and speed as the margins.

So what you could be at risk of is buying what you think is a premium drug company with $70bn of enterprise value and $30bn of debt, and getting a commodity drug company with $29bn of enterprise value and $30bn of debt. And it doesn't even have to be that bad for the business - if it's got $40bn of EV, $30bn of debt and $10bn of legal liability, the short-to-zero thesis still wins.

This is not an investment grade credit. Maybe think about that a bit harder before saying things like " I just can't see how anyone who analyzes companies for a living can remain short after those slides".

How much will the medical industry seek to 'punish' or 'avoid' a bad actor?Valeant has not been liked by much of the medical industry for years but they keep getting net price hikes they like. The net realized to gross price hikes for ophthalmology product was quite strong (as reported in Q3 results).

Philidor says it was compliant with all laws and "highest ethical standards". Yet Valeant has chosen to not exercise it's option to purchase Philidor for $0, despite paying $100 mil to have that option in the first place. That, at the very least, indicates that Valeant thinks there is a non-zero chance that Philidor is a liability (worth less than $0). And since Valeant considered a full range of ownership structures before acquiring the Philidor option and Valeant employees are allegedly staffing some Philidor positions and Valeant has, currently and since the option purchase, the right to appoint a chief compliance officer to Philidor....that means ____?

"So what you could be at risk of is buying what you think is a premium drug company with $70bn of enterprise value and $30bn of debt, and getting a commodity drug company with $29bn of enterprise value and $30bn of debt."

This is wishful thinking by the shorts. They have more than 150 US branded products, just because some shaddy things happened on philidor, that does not make people need less drugs or other products. sure, there will be some issues with regards to growth rates and distribution but who cares, the low stock price has already that embedded in. Its one thing to argue that with the stock at $170, its another at $100. at $100 its not about growth rates going forward, its about fraud, potential settlement costs, etc

@Global - Let's put all fraud allegations aside, what makes it so cheap if growth is factored out? 11x 2015 EBITDA isn't really money on the floor as far as I know. Would be interested in your long case assuming growth is halted and fraud allegations are off the table.

I think the combination of what you wrote about the WSJ article above (Valeant involved in "structures and processes" from its infancy) combined with the Medicis (and Obagi?) models which preceded it, basically everything Valeant has said about Philidor being "independent", "not controlled", etc, is being very economical with the truth.

It is hard to believe MP did not know about this. Given that his reputation is that he himself shows up to negotiate deals to buy companies, it is unlikely that he was not ultra-aware of everything going on and the big picture of specialty pharmacies. This was part and parcel of the models at Medicis and Obagi when he took them over.

Ari Kellen did not join Valeant until Jan 2014 and this was already on its way to doing the wrong things before then. And the plan of how to build this out was fully in place. They may convince somebody that Ari Kellen was responsible, but there are likely too many people out there who know better who will lose their job over this for that to stand.

The question now for Valeant investors might be... Did they hire too good a guy to lead the ad hoc team? If he has any honor, MP will not come out unscathed I expect. He knows explicitly ("but maaaawwwmmmm everyone else is playing in the mud!") that the model is ugly. The question will really be how much of the "hiding things" was his idea, and how much of the aggressiveness was due to his underlings? (heaven knows MP himself has a reputation of being totally non-aggressive).

They have more than 150 US branded products, just because some shaddy things happened on philidor, that does not make people need less drugs or other products. sure, there will be some issues with regards to growth rates and distribution but who cares, the low stock price has already that embedded in

No, you're still not getting it. People might not need less drugs or other products, but they very much might decide not to pay the higher prices that are the bedrock of Valeant's model. If they shipped the same physical volumes, but of generic drugs, they wouldn't generate enough cash flow to service the debt, and the patients would be getting the same amounts of the same compounds. Valeant is economically dependent on keeping some degree of premium pricing, and the question is - can they sustain enough premium pricing to generate enough cash to service the debt, with enough left over to justify the current share price?

So far, a lot of Valeant's earnings growth has come from a) acquisitions and b) price increases. We can rule out a) for the time being, and of course b) is difficult to turn into a sustainable source of recurring growth. So they need to:

1) Not lose too much market share to generic alternatives despite losing their ability to push dispense-as-written prescribing2) Not lose too much market share to non-generic alternatives simply through having alienated the insurers3) Not lose too much pricing in an attempt to maintain market share4) Hope that the customer-stuffing rumours (people with 20 years' worth of foot cream etc) aren't too severe or endemic.

This isn't an investment grade credit. Its 5 year CDS trades wider than 500bp. The market is telling you that there is a material chance that this company will default on its debt, in which case the equity would obviously be worth zero. It's really rather insulting to see someone casually call this "wishful thinking by the shorts". At the very least, I would expect anyone making such a confident statement to have detailed knowledge of the covenants on their revolving credit.

Does anybody wonder how much liquidity Valeant has right now? They had 1.5 billion in cash and an untapped 2 billion revolver at the end of September. But in classic Valeant fashion, they closed three different deals in October that together amounted to a total of about 1.3 billion of immediate outlay (it appears the lady viagra pill has 500 million now, 500 million later).

I've noticed on the Cafe Pharma message boards (and from Valeant's press releases) that they do not appear to be shutting down Phildor quickly at all (certainly not with the speed that you may expect from an honest company that can easily find another specialty pharmacy). I wonder if they're desperate - could be to generate enough earnings to survive the next quarterly earnings report?

The cognitive dissonance of Bill Ackman and the other shareholders is astounding. The question they should be asking is what is the VRX business model worth? Can't raise price, can't acquire, can't use Philidor. What, then, is Valeant good at? Why are you paying more for assets in their hands than the same assets when they were stand alone? Then subtract from that the liabilities, costs of investigation, negative public image, et al associated with Valeant. What do you get?

For Bill Ackman, the problem is even worse. It is very possible that VRX turns out to be a liability for him. He has publicly defended the company. He has compared Valeant to an early Berkshire Hathaway. He has done his diligence on it. The question I would ask Ackman is -- do you really think a company that minimizes cash taxes, raises prices, increases HC costs, cuts job and research,tries to game insurers, and borrows heavily -- do you really think this is a good business strategy? Is it sustainable? Is this good capitalism?

Call me naive but me thinks sound business strategy is about innovation, lower prices, disruption. Not trying to increase your profits at the expense of 1) governments 2) customers 3) employees. That will eventually fail every time.

"This isn't an investment grade credit. Its 5 year CDS trades wider than 500bp. The market is telling you that there is a material chance that this company will default on its debt, in which case the equity would obviously be worth zero"

If you are going to think like that, then every junk rated stock is a short. And we do know the small and medium cap stocks (the bulk of the junk rated stocks) go up in the long-term

Material chance of being worth zero could be 10% (or X%). Which means a 90% (or 1-X%) chance of being worth not zero.You choose the number. Then you choose the value of the case when it is not worth zero. Then you weight the two and you get a "fair value".

The problem with companies with lots of debt is that they have additional triggers to get to have the stock worth zero. Lots of famous investors (including Bill Ackman) talk about the case whether they will have 'permanent catastrophic loss'. The question is really whether they will be forced out at zero. The problem for the VAST majority of investors out there is not whether they will suffer permanent catastrophic loss such that their investment goes to zero and never comes back, but whether someone else FEARS it might, and therefore the person bails. The problem is not that the other person bails but that you bail because the other person did.

Those who bought Enron at $90 and sold at $10 still kept their $10.

Those who bought at $10 because it had fallen 90% lost everything they put into the stock.

"This isn't an investment grade credit". Traditionally, the "risk" that a single-B credit gets worse (i.e. CCC or default) is about 3:2 against getting better (from B to BB, or BBB, or better). That means the volatility is HIGH, and therefore the option price (the stock is a call option on the clearing value of the assets vs liabilities being worth more than zero) is worth more than zero. The question is really "how much more than zero?"

I hope Global Trader bought more at $180, and then at $120, and then even more at $100, and then even more at $90, and then even more here! There is a saying about catching a falling knife that comes to mind...The good news is that it has become a "better buy" the more money you have lost.

Well no, not every junk rated stock is a short. But not every junk rated stock is so obvious a long that "nobody who analyses securities for a living" would not buy it. It's your degree of certainty that I'm objecting to, and your implication that anyone still short at this price is ignoring the facts.

Just by way of conversation, by the way, while we've been having this discussion, the stock which you were unequivocally long at $100, has fallen to $81 plus change. I'm not saying that to make a cheap yah-boo point, but rather to ask - at what level would you stop out? What is it about this stock which makes normal risk management irrelevant?

My old boss always used to correct this to "catching a falling piano". Because there is, in principle, a chance of catching a knife without being cut. But there's no way to catch a piano without being crushed ...

Risk management is an issue here. If Global Trader is right, then Ackman looks like a genius and we all look like cowards. But the undeniable fact is that, win or lose, Ackman has exposed his investors to a large risk of permanent loss of a "high teens" percentage of their capital. If you do that on a regular basis, one day you blow up, with probability one. Even if this turns out to be the single greatest trade of Ackman's already prestigious career, I would still be taking my money away from him.

I'm long through PSH and shorted VRX stock as a hedge as the price action told me something bad was going on. Of course, you won't believe me but I don't care. I will unhedge as soon as this capitulation is over. Thats what this is, capitulation. One asset sale and shorts will be scrambling to cover over $90. I did 'add' to the position today, I shorted the Dec $60 put ($5.4 credit), no hedging. Whoever is buying these puts is a moron

Well, I will be the first to say the Ackman made a mistake in his position size. You just don't put a quarter of your assets in a company levered 5-1. Even if you are right on a market to market basis it will be too much of a hassle, as he is finding out. 25% in KO or indicies yes, in levered companies, no. However, he is still up more than the market by a huge margin and anyone who invested with him (even since his days at Gotham, heck even if you got in Gotham on the last year and them moved to Pershing) cannot complain about his returns. He is also up since 2013, which the Hempton investors cant say

But of course, if the stock price starts to fail to bounce despite the chart being washed out, postive news and a rally that fizzles out. I would have to be an idiot not to hedge/delta hedge. Its only the fundamentals 'only' guys who get killed by these sell-offs. Small players who pay attention to the chart can always bail and get back at any moment

My boss always said "if you try to pick a bottom, you just end up with crap on your hand"

I see three possible outcomes - 1) Pearson gets fired 2) Pearson tries to hang on or 3) Pearson is inseparable from Valeant because if he leaves, the extent of what we will find will be catastrophic for the company.

As far as Ackman goes - the problem for him is that he is lending his reputation to Valeant. And what he doesn't yet understand is that this is akin to throwing good money after bad. He might not be able to buy anymore shares, but he is putting his firm (and himself personally) at risk by being a vocal supporter of the company. And what does the company stand for? Higher prices, higher drug spending, not paying taxes, and, as has been reported on, "back doors" around insurance companies.

As Ackman knows, the press is powerful tool and eventually they will catch up w/ the reality that Ackman, as one of the owners of Valeant, has been supportive of a strategy that increases drug prices for all Americans, while at the same time trying to avoid taxes. Then it will be Ackman with the "New York Times problem".

As far as the accounting goes, look at the gross to net discount Valeant reports in their financing statements. The change from second quarter to third is close to the same size as 20% of total revenues. And don't forget that this is an accounting accrual, based on Valeant's estimates. That is 1) a big change and 2) allows valeant to exercise tremendous control over their reported numbers.

From page 36 of the 2015 proxy:"7) Includes 2,028,516 shares which were pledged in connection with loans used to fund tax and other obligations associated with vesting anddelivery of equity incentive awards and purchases of Company shares. The pledging of the shares was approved by the Company’s Boardof Directors. The amount reported does not include 1,213,435 shares with respect to which Mr. Pearson no longer serves as trustee of the J.Michael Pearson grantor retained annuity trust, of which Mr. Pearson is not the beneficiary and in which he has no pecuniary interest."

Dan Davies,what about this"The struggles over Valeant and Herbalife may have taken a toll on Hempton's results. He says after some very strong years, Bronte has been generally flat, with some periods of gains and losses, since 2013."http://finance.yahoo.com/news/valeants-crisis-fuels-feud-between-144000889.html?soc_src=mediacontentstory&soc_trk=tw

And even if I did no hedging and rode VRX from $100 down to $80 (which is not true), how is that worse than hemptom riding from $120 to $260? he also lost put premiums and paid bond interest. I would assume hempton had to cover some above $200 to keep his position size controlled. Its unclear if he is even up on the investement and if he is, if that gain is anything more than a drop in the bucket. But I don't say this to critize, its a volatile levered company. It doesn't warrant a big position one way or the other

This is ridiculous. I gave you a link to a page which shows the audited results of Amalthea, which is the AUD version of Bronte, since 2013. You can't cherry pick an offhand quote from a story about something else, as if this was a piece of information that was comparable to and capable of refuting the actual data. I am done with you, and rather regret having been polite to you in the past.

I read no mention of "the missing piece" article that came out tuesday / Wed... Bright conversation on here and would think you guys would know all about Kornwasser, the chair audit and the proof laid out on how kornwasser incorporated Phillador the same day he was hired at Valeant, begininng of 2013... Please take a look... Kind of lays out his performance at Medco...

What are your thoughts on "the missing piece" article that came out laying out the involvement of Lazier Kornwasser as an accountant, one hired by Valeant and on the same day Phillador was incorporated in Pennsylvania... This is the same guy that was part of the Medco 2003 scandal years ago... he was not the NAME put to medco, was a big part. Then you have Norma Provencio from Author Anderson... Partner in charge... It lays out there most likely involvement with dates..Ironically Kornwasser was hired in Jan. 13 and on his hire date (Phillador was incorporated in Penn) ... Blatant Fraud will be laid out. The piece tells it all... Can't believe no mention of it here and the basic proof we have. No way this survives and it amazes me that this part of the story is being push aside...I guess it gives all the institues time to unload...Can be no other reason... i have a copy if anyone needs it...

"And even if I did no hedging and rode VRX from $100 down to $80 (which is not true), how is that worse than hemptom"

The issue under discussion is VRX, not your alleged genius stock market outperformance relative to others.

"I see three possible outcomes - 1) Pearson gets fired 2) Pearson tries to hang on or 3) Pearson is inseparable from Valeant because if he leaves, the extent of what we will find will be catastrophic for the company."

I don't think any of those options change the ultimate outcome. #3 speeds it along, and may be necessary to partially untarnish board member names. This turd is so covered with investigatory flies that the truth will come out at some point. Which 3 letter agency or state AG gets the most credit for uncovering the most unsavory and/or criminal practices and when are the primary issues to consider. If Pearson stays, it will be to delay and obfuscate while cash builds to deal with civil penalties.

Someone at Philidor will start to sing when the prosecutors offer deals. It will be interesting to see who ends up serving time. This is the type of case which rockets a prosecutor into the big time (think Rudy Guliani or Chris Christie), so some very smart and ambitious people will be all over Valeant business practices.

I think you can add another pharmacy to this - GENRX (Benzepro Creamy Wash 7% - I just called and they told me that the pre-insurance price is over $700 - for a bottle of Benzoyl Peroxide wash).

This is the fourth "specialized" prescription I've gotten from this particular Dermatologist and the third specialized pharmacy - none accepted my govt insurance, and while my doctors indicated that they would be very low cost or free - they were ridiculously overpriced. I have been able to use ExpressScripts instead for them, and apparently someone is still paying full price or negotiating because they are not generic and the copays are still higher than they should be.

Of note that my daughter has the same dermatologist, and different insurance - and her prescriptions were filled locally with employer-sponsored insurance at a lower copay - and they were generics.

How complicit are the Dermatologists and their medical systems in this whole thing? Why are they driving it? What do they get?

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The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.